Private Equity Pt. 4

How Private Equity Creates Value: Function 1 Dealmaking

The first regular function of a private equity firm is the dealmaking to establish portfolio inclusions. An investment is made, motivated by the belief in potential value growth, held commonly for a range of four to seven years, and then sold or discarded in another manner. The big aspect of private equity is to structure the first deal (purchase/investment) and the second deal (sell/to discard) in such a manner as to maximise profits over this interval. Though this may seem straightforward, this process contains an incredible amount of nuance and effort, and is most often facilitated through the process of mergers and acquisitions (M&A).

The goal of dealmaking for a private equity firm is to create, maintain and develop relations with M&A intermediaries, investment bankers, and other transactions professionals to secure high quality and quantity deal flow. The seven most common types of investment strategies used to acquire companies (See; Types of Funds and Types of Strategies) all require a complicated network of experts to operate and negotiate amongst each other. Depending on the private equity firm’s scope, resources, and requirements there will be different optimal levels of outsourcing or internalising these experts.

Like with any external vs. internal business decision, a company weighs the cost and benefit of externalising or internalising any required parties. This analysis, if done properly will give the optimal ratio of in-house vs. outsourced expertise. There is no golden-rule that dictates that larger firms to have more in-house parties and smaller firms to outsource, they must simply do that which is most profitable.

 

How Private Equity Creates Value: Function 2 Oversight and Management

The second regular function of a Private Equity firm regards the current portfolio entries, and the oversight and management of these. A lot of the activity related to this function is primarily done by active investing; although the same value orientated analytical approach serves as a valuable tool in selecting inactive investments. The approach that Private Equity firms apply to generate or recognise value creation are a set of principles that are applicable across the business domain.

 

1.     Focus on Value

Core to their mission, and crucial in attracting continued limited partners, the sole operational focus should be on value creation; this entails a lot more than cost cutting and other forms of financial engineering. Private equity deals over the years have included substantive operational improvements that are the result of deep industry and functional expertise into the investment. This process starts long before the investment is made, with extensive due diligence into the finances, operations, and opportunities of the prospective company. When a private equity portfolio makes this assessment, their focus is to identify those areas where most value of a company is created relative to its respective cost. In practice this often means abandoning entire lines of businesses that are not drawing on the company’s core strengths and differentiating capabilities.

 

2. Cash is King

Most accurately depicted with the instances of leverage buyouts, private equity firms often finance 60-80% of an investment using debt. This high leverage model motivates the firm to liberate and generate cash as expeditiously as possible. For a strong cash position, general partners often tightly manage their receivables and payables, reduce their inventories, and scrutinise discretionary expenses. As previously mentioned, they can delay or altogether cancel lower-value discretionary projects or expenses, investing only in those initiatives and resources (including talent) that contribute significant value and margin.

 

3. Time is Money

Consistent with the limited timeframe and the urgency to pay down debt the private equity mantra is “time is money”. When actively participating in the companies’ operations, private equity firms will place a huge bias on the first 100 days of ownership and the actions therein. They place massive importance on very concrete changes; business culture, socialisation, and other intangibles are expected to follow as a result. Usually the significant ownership positions that firms take are very helpful in running executive decisions through quickly.

 

4. Long-Term Lens

Although they act with speed, a private equity firm does not forsake a long term perspective. Though the timeframe is limited, 28 quarters (7 years) will require leadership that expects profitability in the long term as much as immediate results. After immediate excess costs within the company are dispensed with in the short term, managers are able to critically invest in new business additions that are in line with their long term vision for the company. Here is where the recognised potential to develop a business or industry is executed upon. The additional capital backing will be able to take a company into international markets, lower production costs per unit, or even consolidate the existing industry.

 

5. A-Team

Human capital is a recognised driving factor within company success. Private equity therefore takes careful consideration towards the talent of the staff at a prospective company. Occasionally a core motivator of an investment can be the strength of the existing management. On the other hand, staff deemed incompatible with future goals are released on a very frequent basis. One-third of private equity’s portfolio company CEO’s exit in the first 100 days, and two-thirds are replaced during the first four years. An external or internal network of experts can then begin to fill the newly vacant position.

 

6. Pay for Performance

Extending upon the fundamental principle of good management, is the appropriate incentive structure. If it isn't the case already, private equity firms will regularly tie the compensation of a given manager, in all its various forms, closely to the performance of the respective portfolio company. PE firms pay modest base salaries to managers, but add in a highly variable, annual bonus program based on individual performance, plus a long-term incentive compensation package tied to the returns realised upon exit. This often takes the form of stock options: a 2009 study in the Journal of Economic Perspectives of 43 leveraged buyouts, pegged the median CEO’s stake in the equity upside at 5.4%, whereas the management team collectively received 16% of company stock. Private equity, unlike publicly owned companies are known for completely dispensing with the bonus structure when targets are not met. The equity ‘owned’ by management is essentially is illiquid until the private equity firm exists, which further ties the short, median, and long term goals of the owners and managers closer together.

 

7. Stretch Goals

A final element to the oversight and management of portfolio entries is that of the goal setting. One might refer to the often used but technically inaccurate adage: “Shoot for the moon. Even if you miss, you'll land among the stars.” The oversight and management of companies is assessed through a set of key customised metrics. It is common practice to set aggressive and ambitious targets using these metrics, for which management is adequately compensated if they are met. A general preference for private equity when it comes to assessing success is; cash over earnings and return on capital invested over for example return on capital employed.

 

There is a clear reason that those individuals who can afford to invest in private equity regularly return to do so. These firms are able to combine elite talent with strategic approaches that over and over again are able to add substantive value to a firm that may otherwise perform mediocrely at best or be failing at worst.

Post-editing by Isabel Lihotzky

Kariem HafezComment